Zaks Investment Advisory Service

Economic and Financial Transformations in the Modern World

Last time, we concluded our program by stating the following useful fact: Exchange-Traded Funds (ETFs) allow regular investors to perform investment strategies that, until recently, were only accessible to professionals. For example, they may now invest in a wide universe of foreign stocks. Here, I must digress a bit and talk about the international economy and stock market growth over the past 15 years.

With the fall of the Berlin Wall in 1989, the collapse of the Soviet Union in 1991, and Deng Xiaoping’s 1992 reforms in China, the global economy underwent radical change. Nearly 300 million citizens of the former Soviet Union, 120 million people from the Eastern Bloc, and 1.2 billion residents of China were suddenly rushed from planned, socialist economies into near-market or in some cases fully-market ones. And this transformation occurred in just a few years, or measured in a historical time frame, almost instantly. All of these untold millions of people, who had lived under planned economies for the preceding decades mostly producing things that they were ordered to produce by the planning committees, were suddenly producing things that people actually needed! Their labor efficiency multiplied several-fold. And even though almost all of these countries underwent very difficult transition periods, after a few years, their economies began to grow. Moreover, most of these countries organized their own stock markets, where shares of local private companies began to trade. Just like the economies, many of these exchanges began to quickly grow. In 1992, the total capitalization of all the Chinese exchanges was close to zero. Right now, it stands at nearly three trillion dollars. The capitalization of the Russian exchanges, which did not even exist in 1992, is now about one trillion dollars. (Just for comparison’s sake: the market capitalization of all the US stock markets is near 20 trillion dollars.).

Of course, just like their economies, the stocks markets of nearly every developing nation experience numerous difficulties. Many of the economies are market only in name, while in practice remain largely controlled by the state. Most of these countries are ridden by corruption (with the exceptions of Slovenia, Estonia, and to a lesser extent, some of the other Eastern European countries). Stock market price are often subject to manipulation by the insiders and the state. In many countries, the ruling regimes have allowed the so-called oligarchs to expropriate the most productive assets. And yet, compared to their old planned states, all of these countries became incomparably more productive, and consequently, people’s standards of life grew.

Moreover, transitions to semi-free, near-market systems did not benefit the people of these nations alone. They also helped the developed ones: the United States and Western Europe. The fact of the matter is that most of the developing countries would have been unable to emerge from their economic crises, which planned economics provoked, by relying solely on their domestic markets: these markets were simply too small. But, to their fortune, we live in an era of global economics. Almost all of these countries found something they could export to the more developed and richer nations. China and other countries of Southeast Asia are exporting an enormous amount of consumer and so-called low-tech goods. Russia exports oil, natural gas, metal and timber. India exports information technology. Brazil – iron ore, coffee and other agricultural products. Eastern European countries are exporting goods produced in factories that Western firms built there to efficiently use the local cheap labor force. As a result, many of the products and services that were once produced inside developed nations by an expensive labor force are now being produced in emerging markets and sold to developed countries at lower prices. On the one hand, this has resulted in a loss of some jobs in the United States and Western Europe. But one of the economic features of the developed nations is their flexibility: almost all of these countries were able to quickly adjust and move to production of more high-tech goods, and more sophisticated services. For this reason, fewer people in the developed nations are now involved in the production of goods, and more are taking part in these goods’ development. This process is for the large part responsible for inflation remaining relatively low in the Western world over the recent years. And thanks to this very same process, the standard of life in the emerging nations has risen sharply.

We, as investors, are interested in stock markets. Economic growth is a wonderful thing, but what we care about are rising share prices, and the two do not always correspond. The connection between economic growth and rising stock market prices is a very interesting and far from self-apparent subject. The fact is, stock prices are not determined by the economy as a whole, but by the profitability of companies whose shares are traded on the market. Imagine a country where development occurs mostly thanks to small and medium-sized private firms whose shares are not publicly traded. This fictional country also has huge privatized companies whose shares do get traded on the exchanges. But to the great disappointment of investors, the management of these companies turned out to be incompetent and corrupt, and these companies see no profits. So, this country’s gross domestic production grows, while the stock prices stay put. You may think that this is a theoretical example that has no precedent in real life. This is not quite the case: in our next program, we will discuss one country where things just about followed this scenario.

But with this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.